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Bubbles and Crashes

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Story of a typical technology stock

It not only provided support for such a technology but also provided the informational content itself.

It’s IPO price was $1.50 per share. Six years later it was traded at $ 85.50 and in the seventh year it hit $ 114.00.

The P/E ratio got as high as 73.

The company never paid dividends.

About RCA: READ Bernheim et al. (1935)“The Security Market” Findings and Recommendations of a special staff of the 20th century fund - p. 475 and following

Story of RCA - 1920’s

Company: Radio Corporation of America (RCA)

Technolgoy: Radio

Year:1920’s

It peaked at $ 397 in Feb. 1929, down to $ 2.62 in May 1932,

Dec 25

Dec 50

(was < $ 14 till June 1945)

Internet bubble? - 1990’s

Moving right along to the 1990’s

NEMAX All Share Index (German Neuer Markt)

NASDAQ Combined Composite Index

Chart (Jan. 98 - Dec. 00)

Chart (Jan. 98 - Dec. 00) in Euro

38 day average

38 day average

Loss of ca. 85 %from high of Euro 8,583

Loss of ca. 60 %from high of $ 5,132

Was it a bubble?

Why do bubbles persist?

Do professional traders ride the bubble or attack the bubble (go short)?

What happened in March 2000?

If it was a bubble, the question arises …

Do (rational) professional ride the bubble?

South Sea Bubble (1710 - 1720)

Isaac Newton

04/20/1720 sold shares at £7,000 profiting £3,500

re-entered the market later - ended up losing £20,000

“I can calculate the motions of the heavenly bodies, but not the madness of people”

Internet Bubble (1992 - 2000)

Druckenmiller of Soros’ Quantum Fund didn’t think that the party would end so quickly.

“We thought it was the eighth inning, and it was the ninth.”

Julian Robertson of Tiger Fund refused to invest in internet stocks

Pros’ dilemma

“The moral of this story is that irrational market can kill you …

Julian said ‘This is irrational and I won’t play’ and they carried him out feet first.

Druckenmiller said ‘This is irrational and I will play’ and they carried him out feet first.” Quote of a financial analyst, New York TimesApril, 29 2000

Classical Question

Suppose behavioral trading leads to mispricing.

Can mispricings or bubbles persist in the presence of rational arbitrageurs?

What type of information can lead to the bursting of bubbles?

Main Literature

Keynes (1936) )bubble can emerge

“It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself.”